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Dissecting Wells Fargo's Fraud

Wells Fargo opened 2 million unauthorized accounts for unwitting customers.

The nation’s third biggest bank by assets got caught with its hand in the cookie jar. Last week, Wells Fargo(NYSE:WFC) agreed to pay a $185 million fine to banking regulators after an internal investigation showed that employees had opened 2 million checking and credit card accounts for customers between 2011 and 2015 without the consent of the accountholders.

The Motley Fool’s Gaby Lapera and John Maxfield discuss Wells Fargo’s settlement with regulators in this week’s episode of Industry Focus: Financials. Listen in to learn more about it, including whether or not this should change your investment thesis in the California-based bank.

A full transcript follows the video.

This podcast was recorded on Sept. 12, 2016.

Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You are listening to the Financials edition, filmed today, on Monday, Sept. 12, 2016. My name is Gaby Lapera and joining me on Skype is John Maxfield, The Motley Fool's top bank analyst. Thanks for joining us, John. How's it going?

John Maxfield: It's going great. Thanks a lot for having me, Gaby!

Lapera: Absolutely. We have an absolute whopper of a story and who else would we have join us but you?

Maxfield: This is a pretty good story, probably one of the best since I've been at The Motley Fool.

Lapera: To take our listeners out of their suspense, we are going to be talking about Wells Fargo. You probably guessed that, though, if you've been anywhere on the internet since Friday.

Maxfield: Just like on a major site, let's say Google, for example, or Yahoo!, but if you're on those random sites, then maybe you wouldn't have come across it.

Lapera: Yeah. I don't know who you are, though. Let's talk about what happened. Wells Fargo -- they found out that they had opened up to at least 2 million false accounts, accounts that shouldn't exist. They have been fined $185 million by a variety of agencies, and they have fired 5,300 employees in direct connection to this case. This is crazy! Oh my God!

I was just talking to a friend of mine and she's like, "I don't understand what the big deal is." We are going to tell you on this show why this is such a huge deal in case you don't already know. John, do you want to talk a little bit more about exactly what happened here?

Maxfield: Yeah. Wells Fargo... You can think about banks. You can analogize them to retail stores. Right? These are stores where you walk into and people try to sell you things. Right? A bank branch isn't just a place where you walk into and you are going to cash a check and nobody's going to ask you to buy any additional products. The difference is that, because it's not a tangible product, it's not as obvious. In the banking industry, the best bank when it came to cross-selling additional products to customers that walk into its stores, not at its branches, it calls them stores, Wells Fargo was the best when it came to cross-selling products. In the most recent quarter...

Lapera: Wait one second.

Maxfield: Go on. Sure.

Lapera: Just so you guys know, bank products are considered things like mortgages, credit cards, checking account, savings accounts -- basically anything you would want to do at a bank. That is considered bank's products.

Maxfield: Right. Let's say you go into a bank. You want to cash a check. You're just minding your own business, you walk into a bank. You got a check from your aunt for your birthday. You need to cash it, get your $100, and go down to whatever, wherever it is that you want to spend your $100. While you are there, the teller would say like, "Oh, well, Gaby, would you also like to get a mortgage or an auto loan? Would you like to open another account? A savings account that you can supplement your checking account with?" A lot of times -- and we all know this, we all go into retail stores -- the customers say no.

This is a problem for Wells Fargo employees because its sales culture incentivized, in fact almost by the sounds of it, demanded that they constantly be selling these additional products. The problem is that there are not a lot of people walking into bank branches nowadays. The Wells Fargo employees, it sounds like, had to come up with a workaround. The workaround that they came up with was that they would sign customers up for accounts and credit cards and other types of banking products and services without the customer's approval.

Let me give you a very specific example. You go in. You say you don't want any additional products, but they actually sign you up for, let's say, an additional checking account. They didn't just stop at that. They would then go to your other account, the one that you had had for a while, that you had money in, that was authorized, that you would use. They would transfer, without authorization, money from that account into this new secret unauthorized account. The problem in that case is that in many instances, it caused those original accounts of customers to have insufficient funds fees. You are not only opening an unauthorized account, but you are also costing people money because you're moving their money without approval and that's causing their accounts to dip below the minimum balance.

Lapera: What's really interesting is that sometimes people would catch them and say, "Hey, I don't know where my money went, and I suddenly have this overdraft account. Fix it." Wells Fargo would go, "Oh, I'm so sorry," and fix it right away, but not everyone caught it.

Maxfield: That's right. In Wells Fargo, the way it works is, Wells Fargo would say, "Oh this was a one off deal. It was a mistake. It wasn't intentional," but what we came to find out in the settlement, this behavior was actually systemic and spread across the entire company. One of the things that Wells Fargo tries to... The way they're trying to pitch this is, "Look, this behavior is the exception. It is not the general rule in terms of how we operate toward our retail customers." The problem with that position is that we are talking about 2 million unauthorized accounts. That is far too many for this to be some sort of isolated scheme.

On top of that and to your point, Gaby, while Wells Fargo fired 5,300 employees, it goes out and says, "That's just a fraction of the roughly 250,000 employees that we have at the bank. This is just a very, very small little group." If you actually look at where their employees are actually allocated, it's only 100,000 of them are in their stores. This means that more than 5% -- in other words, a very meaningful percentage of its employees -- in its retail stores were engaging in this type of behavior.

Lapera: These were the ones that were caught. These were the ones that someone audited and found. There could, potentially, be other accounts. Is that correct?

Maxfield: I mean, I suppose that's totally a possibility. The other thing to keep in mind to your point about that, these are not just allegations that are being made by the banking regulators. In fact, where we got those 2 million unauthorized accounts figure from was actually from an investigation that Wells Fargo did of this problem. This is coming straight from Wells Fargo. These aren't just allegations where you have to say Wells Fargo neither admitted nor denied. I mean, Wells Fargo, for all intents and purposes, has admitted what happened here.

Lapera: Yeah. This is really interesting. Just to get back to a point you were making earlier, we've talked on this show about how much pressure Wells Fargo puts on its employees to cross sell products. This is kind of a natural outgrowth of that if you don't have a lot of checks and controls. I guess my question here is how high up in the Wells Fargo hierarchy do you think this goes? Do you think upper management knew this was happening or were people who were lower down just so desperate to try and make quotas because of the, frankly what it sounds like, punishing environment if they didn't that they decided to do this fraudulent activity? Where do you think it falls in between those two poles?

Maxfield: I think that is the question right now that needs to be addressed. I think there's two ways to look at this. First of all, John Stumpf, the chairman and CEO of Wells Fargo -- I've followed John Stumpf for, basically, the entire time that he's been CEO. In my impression, I've always had a really good opinion of John Stumpf. It would surprise me if he sat in his office and knew that millions of accounts were being fraudulently opened. That would surprise me. At the same time, when you think about the scale of what's going on here, it's almost beyond my imagination that this didn't go higher up in the company. Because, how would you not know about something this large?!

The other thing to keep in mind is that all of this behavior relates to the time period between 2011 and 2015. OK? This is a period, and we've talked about this a lot on the show, where banks are really struggling to earn the type of revenue that they're accustomed to earning, to earning the type of profits that they're accustomed to earning, and the reasons that interest rates are so low. What that means is that puts pressure on banks to find other ways to generate revenue.

You can generate revenue either through interest income or through non-interest income. Non-interest income comes from these account fees and stuff like that. The exact types of things that happened in this case. You think, "Oh, not only does it makes sense that these employees were incentivized to cross sell additional products, but it makes sense that all of this happened when it did because Wells Fargo, along with every other bank, was struggling to generate revenue." Evidently, somewhere down in the chain of command, they thought that one way to do that was to short circuit the system and open these fraudulent accounts.

Lapera: The other thing to think about, you mentioned that this is a much more stringent regulatory environment. This is kind of coming in a long line of abuses that banks have had, not just Wells Fargo. I think the most famous ones would be the overdraft fees on credit cards, charging them in the order such that the bank makes the most money. Then, of course, the mortgage fraud settlements that a bunch of banks have had to do. In fact, talking about that, this isn't the first time that Wells Fargo had to pay out even this year because in February of this year, they agreed to pay $1.2 billion as part of a mortgage fraud settlement which was brought against the company in 2012. Of course that was for mortgages that were given out right before the financial crisis, but it's one of those things that you see this in the news and you are like, "Why Wells Fargo? Why? You should have known so much better at this point."

Maxfield: Yeah. That overdraft thing. That was on debit cards. I mean, to your point Gaby, this is not just an isolated incident at an isolated bank. This is a pattern of behavior that is anti-consumer that is going on and has been going on for many years in the banking industry. If there's any bankers listening to this, I know that they would deny that, but the facts are simply just too clear that that's what's been going on.

If you go back, you have the overdraft thing that is the point you made. That was a really bad thing because what they were doing is they would go in and surreptitiously... They would disclose the fact that they did this in those 20-page agreements that you would sign when you need to open an account, but nobody reads those. Right? For all intents and purposes, the typical person probably had no clue that this was going on. You would go in.

Let's say you had five transactions in a day. Four of them were for lattes. Right? $2 each or I guess lattes aren't $2. What, am I living in the mid-1990s or something?! I want to say lattes are, what, like $4.50 each or whatever it is. Then you had, let's say, a car. You had to fix your car. You paid to fix your car, let's say, $1,000 fee. Let's say that that final transaction, was the last one. That $1,000 transaction was the last one that day. That one kicked you into a negative balance, which then triggered overdrafts. What banks would do is they would take that one and process it first before your lattes and that would kick all five of those transactions into overdraft. That's really bad behavior and, in my opinion, besides this most recent case of Wells Fargo, that was really the worst thing that banks have been doing to consumers.

If you go back to around the internet bubble, all of the big banks' analysts were pumping stocks that they shouldn't have been, that they were purposely inflating the price estimates on and being overly optimistic about them in order to get clients for their banks. They were basically throwing the retail customers out in order to get wholesale customers. They had all the mortgage stuff that you were talking about. The mortgage stuff was really bad because the mortgage servicing behavior that the banks were engaging in after the financial crisis, not only kicked people and families out of their homes, but ruined their credit scores. They would go in and wrongfully, in fact illegally, foreclose on people with fraudulent banking documents. Again, this is not just one bank. All the big banks were doing this kind of stuff.

To your point, Gaby, -- you'll probably ask about this in a second -- what are banking customers supposed to do? Right? If you're a Wells Fargo customer, where are you going to go? Because every other bank seems to be doing the same type of stuff.

Lapera: Yeah. I have to disclose I feel like, I closed down my Wells Fargo account in 2014, I want to say it was. As soon as I left Lincoln, Nebraska, because that was the only big banking option in Nebraska. As soon as I left, I closed my Wells Fargo account and moved to Bank of America(NYSE:BAC) and have had a much better experience. I think I was telling you earlier that I think that's the only time in history that anyone's like, "Wow. Bank of America is so great!" I feel like I should let listeners know that I am a little bit biased when it comes to Wells Fargo on a personal basis, but I'm going to try and keep that out of it.

Going back to what you were saying, I don't know. I don't know what consumers should do. If it were me, I would probably leave, but that doesn't mean that you necessarily should. I think you should go over your bank statements to make sure that you only have products that you actually signed up for. What do you think? What would you do if you were a Wells Fargo customer? Are you a Wells Fargo customer?

Maxfield: I am not a Wells Fargo customer. I am a Bank of America customer as well. Here's the thing to keep in mind in terms of whether customers should leave. It's not necessarily whether they should leave, but it's whether they will leave.

Lapera: That's true.

Maxfield: Should you leave if your bank is doing this to you? Uh, yeah, right? I mean like or else what is going to cause you to leave your bank? The market should be sending signals to the banks through customers coming and going that either affirms what they're doing or goes against it or denies it. Right? This type of behavior should not be permitted in the market. The problem is that there are inefficiencies in the relationship between the consumer and the bank that makes it difficult for the consumer to just leave their bank even if the bank is doing something egregious toward them.

Let me talk specifically about that. There are these things called switching costs. Let's say, in your situation, you left Lincoln, Nebraska, you want to open a new bank account. Right? The problem is that let's say you already have an established job, so you have direct deposit going into that account. Let's say you pay all your bills out of that account automatically. You have all of these strings that go out from that bank that make it really difficult and inconvenient at the very least to go from one bank to another bank.

It's for this reason that studies have shown, in the past, that the switching costs of switching from one bank to another is really high which insulates banks from the downside of bad behavior of customers leaving. Whether you should or should not, you probably should. Whether you actually will, that's totally dependent upon whether you're willing to go through the time and inconvenience, which most people aren't, of switching your accounts.

Lapera: I was. That's a story for another time. That actually does bring up something that I want to talk about. Obviously, you said that banks are insulated from customers leaving. Do you think that partially explains what we've been seeing in Wells Fargo stock price? I don't know if anyone has looked at it recently, but month to date, Wells Fargo is only down 4%. The KBW, the bank index, it's down 0.72%. You would think that after this kind of shocking news that Wells Fargo would be way farther down, but it's not.

Maxfield: Yeah. I think kind of to the point that we've made. All the other banks have engaged in similar types of behaviors. Basically, they're all the same. It's not like... I don't think investors are going to go out and punish Wells Fargo much more than they're punishing other stocks. I think it's pretty much been presumed almost over the last decade that unfortunately, this type of stuff goes on. Even beyond this, let's not lose sight of the fact that... I mean, this is egregious what Wells Fargo did. It's horrible, but it's still an incredibly well run bank.

Lapera: To that point, I just want to point out I have a table in front of me that has the fines paid by banks over the last eight years. Bank of America is around $58 billion. JPMorgan(NYSE:JPM) is around $31 billion. Citigroup (NYSE:C)is around $13 billion and Wells Fargo is the winner at only $10 billion.

Maxfield: That's a lot of money.

Lapera: Yeah. That's a lot of money, but it's a lot less than $58 billion.

Maxfield: Yeah, that's a lot of money. So, Wells Fargo did something bad, but on a relative basis, it doesn't seem to be as bad as many of its peers. Then when you look at the fundamentals of its actual business, they're good at managing credit risk. They run an extremely efficient operation and as a result they have one of the highest profitability figures in the industry, other than U.S. Bancorp (NYSE:USB). When you counterbalance this one instance, which earlier in the show you said it cost $185 million for Wells Fargo, that's a big fine for you and me, but for Wells Fargo, that is a fraction of the $5.5 billion or so that it's earned.

Lapera: That's basically an accounting error at that point.

Maxfield: Yeah. It's like a slap on the wrists. When you factor in and you look at the other terms... the consent order between Wells Fargo and the Consumer Financial Protection Bureau which was the regulatory bureau that headed the action up against Wells Fargo, they're just not very stringent requirements. When you counterbalance all the good that Wells Fargo brings to the table, I still think that heavily outweighs the bad of this instance.

Lapera: Your investment thesis, what I'm hearing, it hasn't changed?

Maxfield: I don't want to say that I approve of this behavior. Not like it matters if I approve or not approve. You know what I mean?! But no, it really hasn't changed my investment thesis. Now, that isn't to say this won't have an impact on Wells Fargo. Because, one of Wells Fargo's core strengths is the fact that it cross sells so much more effectively, now we know why, than other banks. The question is how much does that contribute to its top line and how much does that contribute to its growth? And how much will that be dialed back now assuming that Wells Fargo gets a handle on this type of stuff?

Lapera: It's not just that. Wells Fargo now knows that it's more likely to be examined by a regulator. It's under a regulatory microscope that perhaps it wouldn't have been under before. It's actually a really interesting side story to this. The Consumer Financial Protection Bureau -- which was the agency that brought a lot of these fines -- they are responsible for $100 million of the $185 million fine. They're a really interesting little agency. There was some doubt earlier in the year whether or not they were constitutional and they were even going to survive. Banks had been bringing suits against them.

It's going to be interesting to see what happens with them post this Wells Fargo case because clearly they caught a bank doing something bad against consumers, which is the whole point of the Consumer Financial Protection Bureau. We were talking earlier that all the other regulating agencies for banks, they are there to make sure banks survive and that our financial system doesn't collapse, but that doesn't necessarily mean that they're going to be on the outlook for consumers which is the whole purpose of the Consumer Financial Protection Bureau. Maybe this will add to their case to let them stay even if it's like they are reorganized or something.

Maxfield: Yeah. You bring up probably the most important point for the bank industry, overall, that you can deduce from this case. Talking about the Consumer Financial Protection Bureau, it is pretty common that a new regulatory body comes out of a crisis in the banking industry. If you go back to the Civil War, that's when the Office of the Comptroller of the Currency came along. That's what's in charge of the national banks. After the panic of 1907, that's what led to the Federal Reserve. Then you had the Great Depression which led to the FDIC, the Federal Deposit Insurance Corporation. Those are the three primary, what we call the prudential regulators of the bank industry. What they do, their primary mission is to make sure that banks are operating in a safe and sound manner. Right? We see what happens when they don't in 2008.

What that means is that these prudential regulators are actually to a certain extent, trying to protect the banks from themselves. They are doing this. They are acting on behalf of the banks, to a certain extent. Now, the banks don't always like what the regulators, the prudential regulators, do but it generally is a pretty good thing for the industry from a safety and soundness perspective.

The Consumer Financial Protection Agency is a totally different animal, because it has no interest in protecting the banks. Its exclusive focus is on protecting the consumer, and because banks got so out of control in terms of how they treated consumers the last few decades, that means that the Consumer Financial Protection Bureau is almost innately adverse to banks. For the first time in history in the United States, we have a regulator in the banking industry that is actually opposed to the banks as opposed to on their side.

Lapera: Oh, I don't know. This story, the more you dive into it, the more complicated it gets. I think that we are running out of time, but final thoughts, think for yourself whether or not this changes your investing thesis. I think, generally, this is why people don't like banks. As we were kind of talking earlier with our own personal investing thesis, it doesn't really change it and because Wells Fargo is the least bad of many bad options. That's why people hate the banking industry in general. This is kind of a wait and see what happens in terms of further regulation for all banks, not just Wells Fargo. John, do you have anything else you would like to say?

Maxfield: Yeah. Just to reiterate in my opinion and I'm a shareholder of Wells Fargo, this does not change my investing thesis in a material way. However, there could still be implications from all of this that could change one's investment thesis. For example, if chairman and CEO John Stumpf eventually left as a result of it. Now, that's just speculating that that will happen. I don't think that that will happen, but that could. At that stage, I think it would be worth investors' time to sit down and to think whether something like that would, in fact, trigger you to adjust your investment thesis.

Lapera: All right. Thank you very much. I also want to thank... I believe your name is pronounced Harris Arshad who tweeted me with a question about why Wells Fargo stock was down so little. We, obviously, included that in today's show.

As usual, people on the program may have interest in the stocks they talk about and The Motley Fool may have recommendations for or against so don't buy or sell stocks based solely on what you hear. Contact us at industryfocus@fool.com or by tweeting us @MFIndustryFocus. If you have any questions, or you want to talk about this or you just want to be like, "Oh my god. This is crazy." Thank you again to Austin Morgan. I see you have your Redskins jersey on.

Austin Morgan: I do.

Maxfield: A die hard believer.

Lapera: He's a proud supporter.

Maxfield: Believe, Austin, believe.

Lapera: All right. Thank you, everyone, for joining us. I hope everyone has a great week!

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Gaby Lapera has no position in any stocks mentioned. John Maxfield owns shares of Bank of America, US Bancorp, and Wells Fargo. The Motley Fool owns shares of and recommends Alphabet (A shares) and Wells Fargo. The Motley Fool has the following options: short October 2016 $50 calls on Wells Fargo. The Motley Fool recommends Bank of America and Yahoo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.